The Domino Effect

There are many aspects of the current crisis that the "experts" on Wall Street didn't quite get until recently (and most still don't, it seems).

One is how dependent the U.S. and many of its inhabitants are on borrowed money -- not to mention the ongoing faith and support of its lenders. When confidence starts to falter in any meaningful way, as it did following the housing bust and the subprime mortgage meltdown, it can suddenly spawn a contagious aversion to risk that spreads like wildfire to all parts of the financial system, leading to a rapid decrease in available credit.

When a crunch like this happens, it naturally puts the brakes on all sorts of economic activity, especially in a country like ours where the structural underpinnings are already weak from decades of overindulgence, poor leadership, excessive reliance on financial engineering, bad government policies, and a host of other ills.

The slowdown, in turn, causes bankers and others to be more fearful and tight-fisted when it comes to doling out credit, pressuring the economy still further, engendering a vicious downward spiral. In "Housing Woes Have Domino Effect," USA Today offers up a reasonably good overview of how it all fits together (as well as including some thoughts from yours truly).

If you haven't yet felt the impact of the nation's credit crisis, just wait. Chances are, you won't have to wait long.

So far, the turmoil may feel a bit remote for average people: Failed mortgage lenders. Gargantuan write-downs by banks. Foreclosures for people who couldn't really afford the mortgages they got.

What about the rest of us? Are we in danger? No one knows for sure, but quite likely, yes.

As the credit crisis seeps into farther-flung corners of the economy, more of us will find it harder — and costlier — to borrow money. The value of the funds in our retirement accounts could shrink. People with subpar credit will likely find it more difficult to qualify for auto and home-equity loans. Even consumers who make the cut may need higher credit scores and more documentation.

With loans harder to get, people will hesitate to buy cars, boats and other big-ticket items. The gravest fear? That weak consumer spending — along with surging energy prices, a long housing slump and sluggish job growth — will plunge the economy into a recession.

Even if a recession doesn't occur, "We're going to be in for a rough ride," says Robert Kuttner, a senior fellow at Demos, a New York policy organization. "With job creation slowing down, credit standards being tightened and housing values not going up anymore, the consumer is under pressure to tighten his or her belt."

Becki Carr, 28, of Detroit, says she's growing gloomier about the economy. Her reasons: rising home foreclosures in Detroit, rising heating and gasoline prices and a cloud of insecurity over the area's job market. As a result, Carr says, she's watching her money more closely.

"Pretty much everyone around me is unemployed or they are having to travel down South to do contract work," she says. And "Every other house on our street is for sale, and they've been for sale for the last year and a half. … It makes me double-check my costs and things."

Tighter credit and falling home prices top the reasons why the economy could slip into a recession, according to 50 economists surveyed in late October and early November by the National Association for Business Economics.

Most economists still don't foresee a recession. But the risk of a downturn is growing with each bout of bleak news. About 18% of economists who responded to NABE's survey put the probability of a recession starting within the next 12 months at 50% or greater. That's up sharply from the 11% of economists who said so in August.

A recession would inflict pain on a majority of Americans as unemployment rose and the stock market sank further. In a recession, "Investors have to be prepared to absorb a 20%-plus decline in the value of their portfolios," says Ed Yardeni, president of Yardeni Research, an investment research firm in Great Neck, N.Y.

The benchmark Standard & Poor's 500-stock index hit an all-time high of 1565.15 on Oct. 9, but since then, it's fallen nearly 8% to 1440.70. The S&P index, which tracks large-company stocks and accounts for about 75% of the market's value, is up 1.6% for the year.

What's managed to help prop up the stock market so far is the sinking dollar, which has nourished companies that depend on foreign sales, says Gregory Peters, chief credit strategist at Morgan Stanley.

Peters says the indicator he's watching most closely, to gauge the likelihood of further economic deterioration, is the labor market. Job growth has clearly slowed but has still held up "reasonably well," he says. U.S. employers created an average 118,000 jobs in the three months through October, down from 142,000 during the first three months of 2007, the Labor Department says. The jobless rate last month was 4.7%, up slightly from the recent low of 4.5% in June but far below the 6.3% of June 2003.

Still, what began as a housing industry downturn more than a year ago has widened into a broader financial industry crisis. Too many risky mortgages were made to people who eventually couldn't afford their payments. Many such mortgages were bundled into securities that were sold to investors who were often unaware of the risk they were absorbing.

Every week, more bad news

The initial low rates on adjustable-rate mortgages are resetting to higher rates. And with housing prices in many markets falling, overextended buyers can't refinance. Delinquencies and foreclosures are rising. Banks and other investors holding downgraded securities tied to risky mortgages are writing down their values billions of dollars at a time.

Each week brings fresh evidence of how the credit crisis is causing damage. Last week, for example, the stock market fell after Goldman Sachs downgraded the nation's largest bank, Citigroup, to a sell. Goldman said the bank would likely have to write down $15 billion over the next two quarters, mainly because of its exposure to risky mortgage securities.

And darker days probably lie ahead: Mortgage-related losses industrywide are likely to mount through 2009 and further bruise financial institutions, says Mark Zandi, chief economist at Moody's Economy.com.

Such losses eat away at banks' capital reserves. That means they can't lend as much money. Goldman Sachs analysts predict that, overall, banks' exposure to risky mortgages could reduce the credit available to consumers and businesses by a staggering $2 trillion.

Even the $2.5 trillion muni bond market hasn't escaped the credit crunch's damage. Muni bonds are issued by cities and states to raise money for projects such as schools, highways and airports. Historically, they've been relatively safe investments because it's rare that governments default on their debts.

But worries about the companies that insure hundreds of billions of dollars in muni bonds are rippling through to muni bonds and rattling investors. The insurers, which have exposure to risky mortgages, could see their credit ratings reduced. If that happened, the muni bonds they guarantee would be downgraded, too. Cities and states would find it harder to raise money. Projects would be delayed. Taxpayers could face higher taxes.

Miami-Dade County and Puerto Rico have postponed bond issues totaling $1.5 billion in recent weeks because of credit concerns.

In the housing market, tightening credit has shrunk the pool of potential buyers for homeowners such as Glynnis Fairbanks, who wants to sell her four-bedroom home in Broward County, Fla.

Fairbanks had a deal to sell her home in May; she thought the sale would be finished by August. But the buyers, she says, had to back out because their lender, Countrywide, tightened its standards on their subprime loan. She's cut her price to $325,000 from $348,000. But only one other potential buyer has peeked at the house.

By the end of 2008, more than 1 million homeowners with adjustable-rate mortgages will see their rates reset higher. Meantime, many people who want to refinance can't because they lack the credit scores or the home equity to meet lenders' tighter standards. This is especially true in neighborhoods where prices are falling. Some people who bought homes with little or no down payment now owe more than their homes are worth.

Investors, too, have been unnerved by the turmoil. Take Doug Breitenbach, 63, who pared back on his investments in financial services this month because of banks' exposure to risky loans.

Since June, "I have lost on paper about $18,000 in my 401(k) fund," says Breitenbach, a retiree in Silver Spring, Md. Though his portfolio is still up for the year, "I'm quite concerned about future drops."

As mortgage-related distress spooks the markets, lenders are becoming "more sensitive" to the risks of other loans, says James Chessen, chief economist of the American Bankers Association. Banks may require higher credit scores now to qualify for loans, he notes.

At the moment, though, many businesses say the credit crunch still feels a little remote. In an October survey of small-business owners, only 6% said loans had become harder to get, in line with survey results over the past two years, according to the National Federation of Independent Business. Only 3% said credit availability and interest rates were their top concerns.

A Federal Reserve survey last month showed little change in banks' lending standards for small businesses. But the same survey also detected a more ominous sign: On most consumer loans, 14 of the 50 banks surveyed had tightened their standards by October. That was up sharply from six out of 50 banks in July. Banks are starting to do the same with credit cards.

Gary Perlin, Capital One's chief financial officer, said at an analysts' conference this month that the company has become more selective about granting credit cards and auto loans. And JPMorgan Chase says it's being more careful about issuing home-equity credit lines and auto loans, mainly for consumers with poor credit.

"When there's less credit extended," says Jack Malvey, chief global fixed-income strategist at Lehman Bros., "it reduces world economic growth and puts the U.S. at risk of recession. The real damage of that could be measured in hundreds of billions of dollars and, depending on what happens to the world economy, it could be $1 trillion."

Discover Financial has jacked up the rate it charges to risky new credit card customers and has raised late fees for all customers. Some banks are likely to consider raising fees or rates on credit cards — one of their most profitable products — because they're under "that much more pressure" in an uncertain economy to recoup mortgage losses, says Edward Woods, senior analyst at Celent, a market research firm.

That means that even those with pristine credit aren't likely to escape the spreading credit crisis. Curtis Arnold, founder of CardRatings.com, says he's seeing more credit card issuers shrinking consumers' credit lines.

"They try to lower it typically where it's within $100 or $200 of your balance," Arnold says. "If you're revolving a balance, you're vulnerable. Just because you have a good credit score, you're not out of the woods."

Eddie Ward of North Little Rock worries that any change in his credit card terms would make it harder for him to pay back $20,000 in debt. "I haven't seen much change yet, but I'm sure there will be over the next few years," says Ward, 31.

Credit bureau TransUnion's TrueCredit.com division has begun recommending that consumers maintain a credit score of at least 680 to qualify for prime rates. For years, TransUnion had recommended a score of only 650 or above.

Its rival Equifax has introduced a service to analyze a lender's portfolio to figure out the probability that existing customers or new applicants have adjustable-rate mortgages. Based partly on this factor, lenders could decide to withhold, or to increase, credit to certain consumers.

That service helps lenders "understand where the (potential) problem is," says Dann Adams, president of Equifax Consumer Information Solutions.

As credit tightens, "The most overextended borrowers are going to be affected the most, and the hardest, then people on the cusp," says Peters, the Morgan Stanley credit strategist. But even low-risk borrowers face "tougher times," he says.

In recent years, consumers have borrowed record-high amounts from credit cards. Revolving balances on credit cards are at an all-time peak, with U.S. households owing a monthly average of $6,960 in the year that ended in September 2007, up 41% from four years ago, according to Synovate, a research firm in New York.

The danger is that households that rely heavily on credit "could get into trouble" as the economy slows, says Andrew Davidson, a vice president at Synovate. "Their incomes are low on average, and they're more likely to get hit with late and over-the-limit fees."

'Wages are squeezed'

Consumers who pulled money out of their homes as the market soared in recent years will also be in for a shock as home prices fall during the worst real estate recession since the Great Depression.

Kuttner says he believes that consumers' recent "reliance on home equity and credit card loans isn't because middle-income people are going on shopping sprees, but because wages are squeezed."

Home-equity withdrawals accounted for up to $324 billion a year in consumer spending from 2004 to 2006, according to estimates from Federal Reserve economist James Kennedy, based on a paper he wrote with former Fed chairman Alan Greenspan. These withdrawals and related consumer spending plunged in the first half of this year as the housing market weakened, according to updated estimates from Kennedy.

In many parts of the country, home prices are expected to drop through next year, with the biggest discounts in Florida, California, Nevada and Arizona. Those declines will curb consumer spending.

By the time the housing slump bottoms out, $1.7 trillion in housing wealth will have been lost, economic consulting firm Global Insight estimates. For each dollar that a home falls in value, consumer spending falls by 4 cents to 9 cents, Fed Chairman Ben Bernanke recently told Congress. That could lead to a drop in consumer spending of as much as $153 billion over several years. While that's no pittance, it's only a fraction of the $9.2 trillion that consumers spent in 2006.

Consumers, in turn, are likely to have difficulty gaining access to money. Peters, the Morgan Stanley credit strategist, says the "virtuous cycle of packaging and selling credit has turned vicious."

"The impact on the economy and consumers has yet to fully play out," he says. "We're still in the early stages."

Investing: Stocks could fall into bear market's clutches

Investors have already seen some of the financial market fallout caused by indebted homeowners defaulting on their mortgages and banks losing billions of dollars from bad bets on securities tied to risky mortgages. Shares of banks, mortgage lenders and retailers have suffered their own private bear-market pain.

Neither has produced a broad stock market "correction" of 10%. A 20% decline, which is a bear market, hasn't happened in almost five years. But that's the risk. While this worst-case scenario may not pan out, it can't be ruled out, either.

"Bear markets occur during recessions," says Ed Yardeni, president of Yardeni Research. "Usually, the stock market anticipates a recession and stocks continue to decline as the economy first sinks into recession. Investors need to be prepared to absorb a 20%-plus loss."

The risk is if the broader economy takes a big hit. If that happens, it would shift the pain in the stock market from the sectors that have felt most of the pain to date — namely, financial and retail stocks — to the rest of the sectors of the economy.

Predicting tough times ahead, Michael Panzner, author of Financial Armageddon, recommends that investors buy shares of companies that sell stuff that people need to buy no matter what's going on with the economy. Companies that sell soft drinks, tobacco, prescription drugs and toilet paper, for example.

Investors, he says, should play it safe, loading up on defensive stocks, socking away more cash and moving toward the safety of U.S. Treasury notes and bonds.

Despite all the potential negatives, a recession is still a long shot, as are most of the worst-case scenarios, says Jeremy Siegel, finance professor at the Wharton School of Business. He says major banks like Citigroup and Merrill Lynch are unlikely to suffer 80% drops like tech stocks did in the late '90s.

More important, he stresses: Even if a bear market does occur, these steep market drops ultimately lead to "big buying opportunities."

As for retirement-plan investors, they should be investing for the long term, says Nicholas Nicolette, president of the Financial Planning Association. He is telling clients that if an investment is underperforming its peers, they should consider replacing it. But they shouldn't abandon a market sector altogether because of a market correction alone.

When prices are low, it's actually a good time to buy an investment, planners say, as long as the company — and the sector — have favorable prospects. The recent market downturn should also remind investors of the value of diversification, says Judith Ward, a financial planner at T. Rowe Price.

Think about how much of your company's stock you own. T. Rowe suggests holding no more than 10% in company stock in your retirement portfolio.

By Adam Shell and Kathy Chu

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